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Wednesday, 13 October 2010

It’s a racing certainty that more people have lost money following the wisdom of the Sage of Omaha than following tips from any number of other so-called gurus. Of course, it’s perfectly correct that virtually every pearl of wisdom dripping from the lips of the Chairman of Berkshire Hathaway is worth a thousand utterances from the plethora of mass market media mavens masquerading as psychic predictors of the unforeseeable. Unfortunately there are two sides to every equation and Buffett, hard though he tries, can only be on one of them.

The simplicity of Buffett’s approach and his folksie wisdom belie a tough-minded and intensely focused individual whose career has been marked by a single minded determination to make money. Most people don’t see this, though, what they see are the incredible gains that can be made by actively trading and draw the obvious, but mad, conclusion that what’s good enough for the one person capable of defying the logic of markets is good enough for them. Following Warren Buffett without Warren Buffett’s temperament is a one-way ticket to the poorhouse.

Clarity and Consistency

It’s impossible to read Buffett’s letters to Berkshire shareholders – or anything else he writes – without being struck by the clarity of thought and expression that he brings to a world mainly characterised by confusion and inconsistency. If you read most commentators over a long enough period of time you usually find that their opinions have shifted markedly without any public pronunciations, presumably on the grounds that they figure most people won’t notice.

Mainly they don’t, although mainly because they don’t care.

Buffett’s wonderful ability to communicate complex ideas, to explain how the ambiguity and uncertainty of markets can be managed and how to see the dead wood from the living trees is a shining example of how it’s possible to talk intelligently about financial matters to people willing to expend a bit of effort to understand. “Effort after meaning” it’s called, originating with a character called Frederick Bartlett who believed that memory is an active thing, something you create out of your own efforts to recall: his War of the Ghosts experiment is a story still worth retelling.

Unfortunately what this also means is that what is recalled is not always what the writer would like to be remembered; often the message is lost while what remains is a faint reflection of what was intended. Blaming the writer for this is like shooting the piano player: we’re doing the best we can. Still, the messages taken from his writings will often not be what Buffett intended.

Concentration of Activity

A couple of themes seem to arise quite regularly in discussions around Buffett: the ability to generate abnormal returns through active investing and the focus on a highly concentrated portfolio – “put all your eggs in one basket and then watch it like a hawk”. Yet these are possibly two of the worst messages you can take away from the great man.

Active investing is a worse than zero sum game; most people will lose money even if they choose to invest in mutual funds through overtrading and improbably bad market timing. William Sharpe showed this years ago in The Arithmatic of Active Managementin which he pointed out:

"It must be the case that ... after costs, the return on the actively managed dollar will be less than the return on the passively management dollar".

The main problem is, as usual, psychological. Without going anywhere near an analysis of Mr. Buffett’s psyche it’s quite clear that he’s an unusual person – few people sought out Ben Graham as did Buffett, no gentile other than Buffett succeeded in getting Graham to employ him, no one else then decided to branch out on their own with their own unique approach … the list goes on and on. It’s simply impossible to have made as much money as Buffett has done by luck, whatever the theorists may say, and that means that he must be much more capable of managing his own biases than the vast majority of us.

Go Figure, Yourself

The corollary to this is that trying to invest like Warren Buffett without having his mentality is a one-way ticket to penury. Learning the outward signs and investment strategies is one thing but having his psychological strength is entirely another. You’d have thought that after the best part of sixty years that commentators would have the sense to avoid betting against him but, once again when the going got tough people decided that taking a swing at him was a sensible approach. Of course it is, if you reckon today's commentary is tomorrow's electronic garbage.

In the depth's of the 2007-2008 crisis Buffett penned this piece for The New York Times, and it contains more sensible comment on the opportunity from a historical perspective than virtually every other piece of scribblage written during that period:

"Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy."

It provoked some strong responses, many of which pointed out that it was easy to advise people to buy stocks when you weren't personally having to worry about the next paycheck and whether you were going to have a job next month. It also helped having a few billion sloshing around in the checking account, of course.

The point, though, is that having the right psychology is only part of the overall package. Understanding history helps, as does making sure you have enough cash around to take advantage of these occasional - but oddly frequent - market collapses. To act on Buffett's advice generally you've got to think like him all the time, and ending up in early 2008 geared to the gills wouldn't have been conducive to following his lead.

Diworsification

Diversification is another problem, partly caused by Buffett and Charlie Munger who have repeatedly pointed out that you can’t make excessive returns if you buy the market. They’re right because to make really abnormal returns you need to have a concentrated portfolio of stocks. Unfortunately you also have to buy the right stocks and, as we've seen in Diworsification Is Good For You, that's not going to happen by luck. On top of which, quite often, you’ll have to sit tight through some horrendous losses. If you’ve chosen correctly these will be temporary but if you haven’t then it’s a hard way to learn that you’re not Warren Buffett.

Berkshire Hathaway, of course, is hugely diversified these days so is hardly a test bed for this approach. Still, diversification is critical for most investors and figuring out how to be properly diversified without buying the market, and creating your own expensive index tracker, is one of the main challenges for active investors. Not least because people insist on repeating the myth that you can get decent portfolio diversification with as few as fifteen stocks.

Invest in Yourself

Other lessons are just as important but don’t seem to have quite the same power to breach people’s thought barriers. Perhaps the most important is to only invest in things you understand, a so-called "circle of competence". Now, I don’t know about anyone else, but limiting myself to the handful of things I have a decent appreciation of would lead to a portfolio with a focus on small IT stocks, babywear retailers and bugger all else: concentrated to be sure, but optimal?

"Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word "selected": You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices. "

Of course, the point is that investors need to make a real effort to understand businesses before they invest in them above and beyond the pure reading of the balance sheet – although often that’d be a good start. This type of analysis takes time and a lot of effort and these are things that the vast majority of private investors simply don’t have, so they take short-cuts and usually end up holding a bunch of stocks which do things that they only faintly understand, if that.

Understanding a business is the proper way to de-risking it as an investment and is a critical step if you’re going to hold the kind of undiversified portfolio that you need to make truly great returns. For most of us this is very, very difficult – although one suspects that both Buffett and Munger would shrug at this caveat: expecting it to be easy to make lots of money through investing is a category mistake, if it were true no one would need to work for a living.

Warren Buffett Bias

The idea that Warren Buffett Bias drives many investors into foolishly investing directly in undiversified portfolios of stocks without having the proper psychological shielding or the margin of safety that comes from truly understanding the companies in question is no doubt exactly the opposite of what the man himself would wish. Yet it’s likely that this is exactly what’s happening.

We can’t stop the naïve masses from following their suicidal instincts, even when pointed in the right direction, but we can learn the proper lessons ourselves. Invest with humility, be patient when markets crash and never let your psychological biases outweigh your investment skill. Let’s face it, none of us are going to be Warren Buffett. Fortunately we don’t need to be and, if nothing else, we’ve got his writings to peruse and amuse on the long winter nights when otherwise we’d be worrying about portfolio valuations and thinking about trading.

8 comments:

he must be much more capable of managing his own biases than the vast majority of us.

I don't think it's Warren Buffett who has caused more losses than any other financial advisor. I believe that that honor goes to John Bogle. And, yes, I am in some ways a big John Bogle fan just as you are obviously in some ways a big Warren Buffett fan.

I agree that most people shouldn't be picking stocks. But I an offended by the way those who promote passive investing overstate their case. There are millions of investors who are capable of doing what Buffett does (not quite as well, but well enough to make it very much worthwhile for them to put in the effort). Say that it's only 10 percent of the population that possesses this ability. 10 percent is not 90 percent. But 10 percent is not 0 percent either.

The case for passive investing would be much stronger if those pushing it could be honest in their claims. Yes, we should tell people that most are not cut out for stock picking. But no, we should not be flattering those who engage in passive investing into thinking that they are actually smarter than the Warren Buffetts of the world because the Buffetts are just too dumb to see that only passive investing can possibly work.

Real damage is done with these "white lies." If passive investors understood that their approach is a "good enough" strategy, they would approach the investing project with far more humility than is generally in evidence among them today. The great irony here is that the value investors (the good ones, anyway) DO possess humility. It's the ones saying they are better investors than anyone else who lack the most critical insight -- an understanding that we are all capable of getting it wrong at any time. There's no investor more dogmatic than a confirmed passive investor.

I love indexing. I see it as a huge advance. But, as with anything else, there is a right way to go about indexing and a wrong way to go about indexing. Those who believe that they have outsmarted Warren Buffett by learning about indexing are fooling themselves. And that never works out well in the long term, in my experience.

What I find most baffling about Buffett is that he's always talking about the long term, yet he became rich extremely quickly, and Berkshire's value goes up very steadily, year after year, very unlike what one would expect from a long-term-oriented, concentrated value portfolio.

Also, regarding passive investing, I don't think there's any such thing. Index investing just means letting the index pick your stocks, which is basically a momentum strategy, since stocks get on the index by growing large enough. If too many people pile into this strategy, it will stop working, just like every other strategy.

Another thing about indexing is that the supply of quality investments is not necessarily matched to the number of people who need to save for retirement. If retirement savers are all piling into index funds, they become the equivalent of social security, where the retirees' income is just paid by the influx of funds from those still saving for retirement, and there is no connection with the underlying worth of the stocks. This, I feel, is where are now, and as the boomers shift their assets we could see serious headwinds.

Buffett is entirely correct that value investing is easy in principle yet very hard in practice. I believe the main reason is that people are naturally lazy. I remember one professor in engineering who used an example problem from our textbook for a midterm exam. Half the class failed. All you had to do is open your textbook and read it.

Likewise in investing, how many actually read an annual report before purchasing a share of the business? As Jim Rogers once stated that if you only read the annual reports of potential investments you will be leaps and bounds ahead of 90% of the investment community. People are lazy, why do you think so many use analyst reports instead of your personal report.

The second reason people can't invest like Buffett is that you cannot make someone go against their nature. If you are not thrifty by nature it's going to be very, very difficult. You will likely never be a value investor. Some people are naturally referred to as cheap and if you do not have this label from your friends, value investing will be very tough.

Lastly, related to the second point, if you are not an independent person you will not be a good value investor. This should be crystal clear to anyone who has read Buffett's biography, "The Snowball." He lives by an internal scorecard, or a life of independence. He's not afraid of being different, looking disheveled, or what other people think. If you are more worried about keeping up with the Jones you will not make a good value investor. Many people wouldn't say they live this way but their actions (and finances) speak otherwise. Perhaps this is the reason so many CEO's make poor capital decisions. They are more preoccupied with the conpensation of their peers.

I could go on but this is not my blog. I am starting a blog, perhaps you could link.

I saw this article saying Warren Buffett has not generated any alpha in 10 years

I don't think it's surprising, but when you get to the size of Berkshire it's an achievement to simply match the index especially given the determination to not overpay for acquisitions and the resulting (large) warchest. In any case, 10 years is nothing in an investing lifetime.

The next few years will be interesting though: given Buffett's canny use of his cash pile to get preferential terms from cash strapped financial institutions it would be entirely unsurprising to see them outperform for while, once again.

In the end commentators have to write about something, picking out patterns in the firmament of reality is as good a topic as any, I guess. They've got to make a living, but we don't have to take any notice of them.

I agree on the excessive claims made as to the "safety" of index funds.

Of late (risk on phase) I have started to hear the term frontier markets bandied about far too much for my liking.

The Frontier Markets ETFs on offer are expensive (95bps plus), heavily skewed towards liquid stocks which in these markets tend to be banks and property companies (hence highly geared) and predominantly in Middle Eastern markets (and hence geared almost exclsuively on oil revenues).

You'd have to be smoking crack to get up every morning to sell that to people as either cheap or well diversified in good conscience but the lazy mental shorthand that often passes for financial judgement equates Passive with Safe and Cheap.

Likewise, the problem with most "active managers" is that they are in fact just expensive index funds.

If your manager is truly active, smart and has a consistent process then they can make you money over the long term.

Investing in ETFs and similar however, is a guarantee that you get swept up in the herd and the decisions the herd made yesterday.